The Bank of Israel took the markets by surprise on Monday by lowering the benchmark interest rate to just above zero, in an effort to stem a strengthening shekel and fight deflation.

The unexpected move propelled shares on the Tel Aviv Stock Exchange to a new record high and lifted bond prices. The rate cut, which goes into effect on Thursday, also had its intended effect on the exchange rate, with the dollar jumping 1.4% to 3.91 shekels in late trading.

The Bank of Israel cut its base lending rate to just 0.1%, 15 basis points lower than an already record low 0.25%. In addition, the bank’s monetary committee narrowed the interest rate corridor in the credit and commercial bank deposit windows to around 0.1% from around 0.25%, a move economists said was aimed at encouraging the banks to continue lending.

“The monetary committee is of the opinion that, in view of the increased rate of appreciation and its possible effects on [economic] activity and inflation, reducing the interest rate to 0.1% is the most appropriate step at this time,” the central bank said in a statement.

It was the first time Bank of Israel Governor Karnit Flug acted on rates in six months, following back-to-back cuts over the summer when Operation Protective Edge threatened to push Israel into an economic slowdown, or worse.

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On the other hand, it seemed the bank chose to act cautiously, with a more modest rate move that it usually makes. Monday’s decision marked the first time since early 2005 that the central bank had moved rates less than a quarter-point.

Economists were not just taken by surprise – 11 out of 12 economists polled by Reuters had expected no change in the interest rate. Many expressed concern about its impact.

“It’s difficult to understand the decision to lower the interest rate against the background of accelerating economic activity and consumer spending,” said Jonathan Katz, chief economist at Leader Capital Markets. “It appears that the Bank of Israel is a lot more worried about the appreciating shekel, and decided to fight it with what little ammunition it has,” he added. Katz said he was also surprised about the decision, given rising inflationary expectations in the last few weeks and the impact lower rates will have by cheapening the cost of mortgages.

“Lower interest rates could inflate the bubble in the housing market,” warned Katz.

In fact, the Bank of Israel is contending with a host of conflicting economic and financial developments. On the one side, the shekel depreciation that started last summer has been largely reversed in recent weeks. The currency's effective exchanged rate weakened some 10.4% from July through the end of December, a development that policy makers were counting on to lift Israeli exports and economic growth.

Since December, though, the shekel has clawed back some 7.6% of those losses against the dollar. “Continued appreciation is liable to weigh on growth in the tradable industries – exports and import substitutes,” the Bank of Israel said.

In addition, Israel has seen consumer prices fall in the last year – like much of the developed world. Twelve-month trailing inflation was 0.5%, capped by 0.9% in January, which is way below the government’s target range of 1% to 3%.

For some economists, the shekel’s strength and the currency wars that have broken out in much of the developed world justified the rate cut. Other economies face the same problem of muscular currencies and/or deflation, and have reduced their interest rates in some cases to a minus.

“The global currency wars have forced the Bank of Israel to take action, it seems, out of concern that the shekel’s renewed strength will impact negatively on the economy and inflation,” said Idan Azoulay, investments chief at Epsilon Investment House.

Nevertheless, Azoulay expressed concern about the reduction. “The Bank of Israel is taking a big risk, because now it has almost emptied its arsenal, raising the question of how it will deal with future challenges.”

Militating against a rate cut, however, is the raft of economic data in recent weeks, showing that Israel’s economy not only rebounded from the summer slowdown but was gathering pace.

Fourth-quarter gross domestic product grew at a 7.2% annual rate, the government said earlier this month (using preliminary figures).

On Sunday, the Bank of Israel itself said its index of leading economic indicators – the S index – climbed a sharp 0.3%, while it revised the index for the four previous months higher.

Meanwhile, the Central Bureau of Statistics reported that the unemployment rate dropped to a seasonally adjusted 5.6% in January.

“We believe the strong growth that we saw in the fourth quarter is not a one-time event,” said Ofer Klein, chief economist at Harel Insurance & Finance, who forecast strong GDP growth of about 4% for the current quarter.

Klein said that if the rate cut fails to stop the shekel appreciation, “the door is open to further reductions, and even negative interest rates – even if, in our opinion, this doesn’t accord with the state of the economy.”

Haaretz.com, the online edition of Haaretz Newspaper in Israel, and analysis from Israel and the Middle East. Haaretz.com provides extensive and in-depth coverage of Israel, the Jewish World and the Middle East, including defense, diplomacy, the Arab-Israeli conflict, the peace process, Israeli politics, Jerusalem affairs, international relations, Iran, Iraq, Syria, Lebanon, the Palestinian Authority, the West Bank and the Gaza Strip, the Israeli business world and Jewish life in Israel and the Diaspora.